The Costs of Bank Earnings Management

Abstract

This study examines the link between bank earnings management and cost of equity and trading volume, using a broad sample comprising 22,217 banks from 50 countries over the period 1990 to 2006. The extent of bank earnings management in a country is measured using three distributional properties of accounting earnings that suggest poor correspondence between observable accounting earnings and unobservable economic earnings: loss avoidance, income smoothing and earnings aggressiveness. A time-series measure for each of these three dimensions of bank earnings management per country is developed and then combined to obtain a panel data set of overall bank earnings management. The study then examines whether and to what extent these measures of bank earnings management are related to the costs banks incur to raise equity and the amount of shareholder trading of bank stocks. The results show that investors punish banks for manipulating their earnings. While the results for the individual measures of bank earnings management differ, overall earnings management is associated with a significantly higher cost of equity for banks and lower trading volume. The effects are generally larger than those observed for nonfinancial firms in prior studies.

Keywords: bank earnings management, loss avoidance, income smoothing, earnings aggressiveness, cost of equity, trading volume

JEL Classification: G15, G21, G3, M41